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Bitcoin Storms Wall Street

Illustration: Harry Campbell for Barron's

Even as investors celebrate a banner year for stocks, the party next door is so wild there’s no longer any way of ignoring it.

Now Wall Street is about to join in the fun. On Friday, the Commodity Futures Trading Commission green-lighted plans by the CME and the Chicago Board Options Exchange to introduce Bitcoin futures, allowing traders to bet on the price of the digital currency on a trusted exchange. Nasdaq is planning to offer its own futures next year, while Cantor Fitzgerald will introduce a Bitcoin options product.

Because the futures are cash-settled—traders will receive dollars on the settlement date instead of Bitcoin—the Street technically won’t be getting its hands dirty by buying the stuff directly. But make no mistake: getting listed on some of the largest exchanges in the country is a tectonic shift for Bitcoin, which has been associated with drug dealing and called a “fraud” by the chief executive of the nation’s largest bank.

“If it works, you are witnessing the early stages of the birth of a new asset class,” says Bill Miller, the chairman of Miller Value Partners and a longtime value investor who holds about $75 million worth of Bitcoin in his hedge fund.

Banks like Goldman Sachs are considering helping clients execute Bitcoin trades. And once they dip their toes in, there may be no turning back. Paul Chou, whose company LedgerX launched the first Bitcoin derivatives in October, predicted that “within a year we’ll see at least two major investment banks holding Bitcoin on their balance sheet.”

For all of the worries about a reprise of 17th century tulip mania, there are serious financial players who see a future in Bitcoin. Big banks are cramming to figure out how to get involved, say executives at Bitcoin companies.

Their employees are, too. Traders who are paid to make markets in “low-vol products” sometimes have an extra window open on their monitors so they can keep “trading Bitcoin at work,” says Arthur Hayes, who himself leapt from the traditional trading world at Deutsche Bank and Citigroup to start a Bitcoin derivatives exchange called BitMEX.

Today’s Bitcoin craze comes exactly 200 years after the formation of the New York Stock Exchange, when a small group of brokers weary of fraud in their industry decided to draft a constitution and set up rules. A formal structure for the equity market took decades to build. The crypto market is trying to build its own structure, without much guidance from the government, in mere months. But the holes, particularly in keeping the assets themselves safe, have created grave risks for prospective investors.

New money and talent have already flooded into the crypto market. The cumulative value of cryptocurrencies like Bitcoin has skyrocketed to more than $300 billion from $18 billion at the start of the year. Lawyers, hedge fund traders, and brokers—and even some value investors—have rushed in.

Ari Paul, for one, left his job as a portfolio manager at the University of Chicago’s endowment to co-found a cryptocurrency hedge fund called BlockTower Capital this year.

“Traditional asset classes feel very, very ossified,” Paul says. “Alpha is extremely hard to come by. It’s almost about not making mistakes. You have hedge funds fighting to earn a 5% return over whatever their benchmark is, and that’s [considered] a phenomenal performance. We’re seeing opportunities like that almost every other week. It feels a bit like what I imagine trading commodities was like 30 years ago or equities 70 years ago.”

But there is a flip side: “extreme volatility, operational risk, security challenges—so it’s not free money,” he adds.

Yet Bitcoin has certainly seemed like getting free money this year. Despite some sharp reversals, the price of Bitcoin has mostly been on a one-way ride, rising nearly 1,000% since the start of the year to $10,500 on Friday. Along the way, investors have gotten extra treats. In August, the Bitcoin chain “forked,” splitting off a new cryptocurrency called Bitcoin Cash that was designed as a faster payment system. Most Bitcoin owners automatically got Bitcoin Cash tokens equal to the amount of Bitcoin they had. Bitcoin Cash shot up to $400 on the first day of trading, after not even existing the day before.

Coinbase, the largest cryptocurrency exchange in the U.S., surpassed 10 million accounts this year, adding 100,000 new accounts in just three days over Thanksgiving week. (Unofficial counts put the number at more than 13 million, ahead of Charles Schwab accounts, at 10.6 million.) Exchanges and trading houses are reporting soaring institutional volume, too, from five to 10 times last year’s activity. Over the past 50 days, a daily average of more than $1 billion in Bitcoin has been traded globally, according to Chris Burniske, co-author of the book Cryptoassets.

The logic that underpins the bull case for Bitcoin often seems circular: It’s worth more because people want it, and the more they want it, the more it’s worth. That’s not unlike traditional fiat currencies such as the dollar. But for other reasons, Bitcoin isn’t particularly useful as a currency.

Conducting transactions has become only more difficult and expensive because of gridlock on the network. Visa can process 10,000 times as many transactions per second as Bitcoin’s vaunted blockchain.

Bitcoin doesn’t have to be a currency to be valuable, however. Bitcoin bulls tend to argue that it’s more like gold—a store of value that people hold for investment purposes, or for doomsday protection. Like gold, it’s not correlated to most other assets, and there’s a limited supply: Only 21 million will be made. Thomas Lee, the managing partner of Fundstrat Global Advisors, estimates that Bitcoin could account for 5% of the $7.5 trillion alternative-currency market, which is now mostly made up of gold. His 2022 price target is $25,000.

Skeptics like Goldman Sachs analyst Michael Hinds note that Bitcoin has several disadvantages compared with gold. Bitcoin is vulnerable to hacking, disruptions to the internet, and competition from other cryptocoins.

INVESTORS CAN BUY BITCOIN directly from exchanges designed for retail or institutional investors. Those exchanges will let you trade currency directly from a bank account or credit card for Bitcoin and help you set up a wallet to store the stuff. Trading cash for Bitcoin and vice versa can cost less than 1% of the transaction value. But the exchanges have proved susceptible to hacking. The safest way to store Bitcoin is in “cold storage” on a hard drive that isn’t connected to the internet.

Of course, if you lose the hard drive, you lose the Bitcoin. This gap in “custodianship”—a safe way to store Bitcoin and still trade it—is the biggest challenge to getting more institutions involved. Most insurers won’t touch the space.

Many accredited investors can’t buy Bitcoin directly because it remains associated with unsavory actors. Bitcoin is regularly used for money laundering, according to the Drug Enforcement Administration. Some exchanges don’t use “know your customer” rules that are common in any other kind of banking or investing.

There are no exchange-traded funds available yet, either. Investors could buy a security called the Bitcoin Investment Trust (ticker: GBTC), but it trades at a significant premium to the underlying Bitcoin that it holds, and that premium rises and falls in unpredictable patterns.

Large institutional investors have been waiting for products they can buy on the exchanges they already know. “There’s not a day that goes by that a client or a prospect doesn’t bring it up,” said Dominic Marella, the head of business development at Icon Alternatives, a futures broker.

Enter the big Chicago exchanges.

“Over the last few months, we’ve gotten increasing requests from customers” for a product to manage risk, said Tim McCourt, head of equity products at CME. Cboe has similarly seen growing interest from “not only larger asset managers or hedge funds but all the way down to the more traditional retail folks.” The CME futures will start trading on Dec. 18. Cboe hasn’t set a date yet, but says it is “operationally ready.”

The introduction of futures products will add liquidity to the system. But the most noticeable impact could be to the downside. “What the exchanges are creating here is a wonderful tool to fully be able to short Bitcoin,” says Mark Williams, a former trading floor executive who now teaches finance at Boston University’s Questrom School of Business.

Even if Bitcoin gets Wall Street’s imprimatur, that won’t suddenly make it “safe.” The logistics of trading Bitcoin give it unique risks.

Just finding an accurate price can be a challenge, for starters. CME has been working with a London-based company called Crypto Facilities to determine the most accurate Bitcoin price. Bitcoin trades on dozens of exchanges around the world, often at considerably different prices. There’s an active arbitrage trade that helps narrow the gaps, but at any given time the price discrepancy can be 1% or more.

Crypto Facilities uses four exchanges to create a Bitcoin Reference Rate that will be used as the official price to settle trades. But those exchanges have sometimes proven unreliable. It previously used six exchanges to determine the rate but had to exclude two because they restrict U.S. dollar deposits and can throw the price “out of line,” says Timo Schlaefer, a co-founder of Crypto Facilities.

“CME is attempting to use a standard framework and impose it on a nascent digital commodity that is far from standard,” Williams says. “The broader Bitcoin ecosystem is built on clay feet.” Schlaefer, however, calls the system “manipulation-resistant.”

TRADING CASH-SETTLED FUTURES may seem safer than holding Bitcoins, but it introduces its own risks. For one thing, futures trades are settled based on spot prices. “You’re at the whim of the people involved in those spot transactions,” says LedgerX CEO Chou.

LedgerX, the first to market with regulated Bitcoin derivatives, settles trades in Bitcoin itself. It now facilitates $6 million to $7 million in trades per week. Chou traded conventional futures products at Goldman Sachs before his current job, and his Goldman desk would hedge the risk from cash-settled futures by also trading the spot market. But with Bitcoin, that option isn’t available for many institutional players. “I think there’s going to be a point where cash-settled [Bitcoin] futures make sense,” he says, but for now they’re “incredibly risky.”

And trading futures entails using leverage, a factor that may accentuate Bitcoin’s violent price swings. Thomas Peterffy, chairman of Interactive Brokers, took out a full-page ad on Nov. 15 in The Wall Street Journal imploring CME to rethink its plans, because “margining such a product in a reasonable manner is impossible.”

In response, CME said that while there are “issues to work through,” added security tools will allow the exchange to “appropriately manage the risk.”

Among those additional safeguards are margin requirements that will far exceed other products. For now, CME is looking at making traders deposit 35% of their initial investment, compared with 5% for a Standard & Poor’s 500 futures contract. It will also have circuit breakers that will pause trading after swings as small as 7%.

New kinds of coins, meanwhile, are increasingly stealing Bitcoin’s thunder. While Bitcoin accounted for 87% of the total market cap of digital tokens at the start of the year, it makes up about 55% now, according to CoinMarketCap.com.

A danger is that Bitcoin could end up being the Friendster of the crypto world, while the Facebook—the real winner—may still be in development somewhere. Aside from Bitcoin, the other tokens with a recognizable—though nascent—business case are Ethereum, which can execute more sophisticated operations like contracts, and Ripple, which banks can use to speed money transfers.

There are more than 1,200 other tokens too, launched through “initial coin offerings” or ICOs that have drawn increasing capital in recent months. Investors have plunged $3.6 billion into them this year, up from $96 million in all of 2016, according to coinschedule.com.

Even people who think that the token economy will one day be as important as the internet itself say it’s a minefield. “Ninety-nine percent of it is junk,” says Olaf Carlson-Wee, the 28-year-old founder of crypto hedge fund Polychain Capital, which has more than $400 million in assets.

These coins are similar to Bitcoin in that they are built on blockchain or similar “distributed ledger” technology that is powered by multiple computers. But unlike Bitcoin, which is at least accepted at some businesses and can be traded for fiat currency, most new tokens don’t operate like stand-alone currencies and have little to no usefulness outside of the cloud. They raise money by crowdfunding on dedicated websites, allowing people to trade Bitcoin or Ethereum for the new coins they create.

To understand ICOs and the new tokens they spawn, think of the digital “coins” that you can buy (with real money) in some smartphone games. You use those coins to gain access to new levels or weapons. Most new ICO-launched tokens also operate as currencies within self-contained digital worlds. But they promise bigger rewards than a new digital sword to slay a digital dragon. Protocol Labs, for instance, introduced an ICO in August for something called Filecoin. People can use Filecoins to buy cloud-computing storage offered by other people on the network. It raised $257 million, the largest such fund raising ever.

Filecoin may be among the 1% that succeeds. But many are almost invariably pipe dreams. More important from a regulatory perspective, they’re essentially securities without the normal protection that securities receive. In other words, people are buying them mostly for their investment potential instead of their potential as crowdfunded projects. There is little stopping ICO creators from taking their $10 million in proceeds and buying a mansion in Hawaii.

WITH THAT IN MIND, the Securities and Exchange Commission released guidelines in July on how to distinguish a security, which needs to be registered as such, from a crowdfunded project. Despite the regulator’s report, there remains minimal specific guidance on these products.

In the interim, some private players are trying to help investors and entrepreneurs. GDAX, the institutional arm of Coinbase, created a “digital asset framework,” explaining how it will evaluate digital tokens to determine whether they will trade on its platform.

Traditional law firms like Debevoise & Plimpton are also getting involved, helping new token creators prepare offerings and guiding exchanges toward legitimacy. New kinds of investment banks are popping up too, often staffed by people whose background is in raising money for more traditional public companies. It can be quite a culture shock.

“The investment banking industry has been around for more than 100 years, there’s a book of rules, and everyone plays the same game,” says Irina Dimena, who formerly worked at Morgan Stanley but is now head of corporate development of Argon Group, which helps new token creators raise money. “We try to apply our previous experience and best practices, but we are building a new industry. We want to shape this industry in the right direction.”

Venture capitalists and hedge funds have warmed to the space, with Union Square Ventures and Andreessen Horowitz giving millions of dollars to investors like Carlson-Wee to invest in new tokens. And some public market participants are making the crossover. Patrick Byrne, the chief executive of Overstock.com (OSTK), is developing a new licensed token-trading platform. Overstock’s stock price has tripled since SEC guidance eased the way in July.

Other tokens could soon be available to more investors. Grayscale Investments, which started the Bitcoin Investment Trust, is getting ready to introduce a basket of the largest cryptocurrencies by market value in the coming months.

At a CoinDesk conference last week, there was a mix of exuberance and caution. While many attendees may have become millionaires off their Bitcoin stakes, the panelists warned that investors need to know the party could come to an end at any moment. That risk, however, may not be enough to drive interest away from Bitcoin.

“A really important concept in portfolio management is the idea that you don’t care about the risk of an asset” because it’s “idiosyncratic risk and it gets diversified away,” says Paul, the former endowment manager. “If you put 1% of an endowment in crypto, it actually reduces the risk because it’s uncorrelated to the rest of the portfolio.”

That argument is getting harder to ignore, particularly as old-school investors get tired of watching the party next door.

“Eighteen months ago, the typical hedge fund or macro fund would never even dream of writing about Bitcoin or digital currencies in a quarterly letter,” says Michael Sonnenshein, director of sales and business development at Grayscale. “Now their investors are calling them up and asking, ‘Why don’t you have exposure to this asset class?’ ”

The Value Case for Bitcoin

Bitcoin is among the most volatile investments in the world, sometimes jumping or plunging more than 10% in a single day. Its price can fluctuate based on actions by far-off actors, be they miners in China or coders in California.

Still, it’s gaining favor among a group that normally would shun this kind of momentum-fueled craze—value investors.

Murray Stahl, 63, is one of them. Stahl has run the New York–based hedge fund Horizon Kinetics for 23 years, investing in more traditional value investments, like beaten-down stocks. Horizon now manages $5.5 billion in assets, including $100 million in Bitcoin. To Stahl, Bitcoin is “the ultimate value investment,” he says.

For Stahl, the appeal of the investment is that there are a limited number of Bitcoins. There will be only 21 million created, and no central banker can change that. Plain-vanilla investments that depend on the strength of fiat currency for their value invariably become worth less as inflation rises. That makes them questionable “value” investments, he argues. “If your money is being debased, what good is buying a bond that yields 2%?” he asks. “Let’s say it has very high creditworthiness. You are going to get paid, but inflation is at least 2%, and then you’ve got to pay taxes. It is a guaranteed negative real rate of return.”

When Stahl started to hold lunches with clients about Bitcoin around 2014, 99% of them hadn’t heard of it and were particularly skeptical. But many had come of age during the rampant inflation of the 1970s and could remember how it destroyed value. “They understand debasement because they experienced it,” he says.

Bill Miller, a longtime Legg Mason value fund manager whose strategies led his fund to beat the market for 15 consecutive years before trailing during the financial crisis, got interested in Bitcoin about three years ago. Miller, who left Legg Mason in 2016 and started Miller Value Partners, eventually amassed a 5% Bitcoin position in his hedge fund MVP 1, buying in at an average price of $350. Bitcoin now makes up 30% of the fund. He acknowledges it “may very well be a bubble.”

“I consider it an experiment, and it is an experiment that might or might not work,” he says. “There is a nontrivial chance it goes to zero.” Miller sees Bitcoin as a store of value rather than as a currency. Yes, Bitcoin “doesn’t have any intrinsic value, and it is not backed by anybody,” he says. “But what’s the intrinsic value of the painting The Scream that Leon Black bought for $120 million? It is just paint and canvas.”

Murray Stahl considers Bitcoin a value investment.

For now, Miller isn’t looking to buy any more, given that it makes up such a huge portion of his hedge fund. “I’m thinking more about what’s the proper way to size it, given that it has gone up so much,” he says. “But if I didn’t own it, I would buy it today. I would buy at least a 1% position, if not more.”

Others question whether value investors should be plunging into Bitcoin.

David Dietze, president of Point View Wealth Management in Summit, N.J., says he “would steer clear of Bitcoin” and then rattled off a half-dozen reasons: “It’s not backed by any government; it’s not clear that it can’t be hacked; it has no intrinsic value. Sentiment is frenzied; the run-up seems to have no fundamental basis. That chart is scary. This will end in tears.” -- A.S.